VALUATION, CONCEPTS AND METHODOLOGIES
DIFFERENT CONCEPTS
OF
VALUE
INTRINSIC VALUE
• Refers to the value of any asset based on the assumption that there is a
hypothetical complete understanding of its investment characteristics.
• It is a measure of what an asset is worth. This measure is arrived at by
means of an objective calculation or complex financial model. It is
different from the current market price of an asset.
• Intrinsic value is a core concept that value investors use to uncover
hidden investment opportunities.
Factors in measuring Intrinsic Value
• Qualitative factors are such things as business model,
governance, and target markets—items specific to the what
the business does.
• Quantitative factors refer to financial performance and
include financial ratios and financial statement analysis.
• Perceptual factors refer to investors’ perceptions of the
relative worth of an asset.
Discounted Cash Flows
• Discounted cash flow (DCF) refers to a valuation method that
estimates the value of an investment using its expected future
cash flows.
• DCF analysis attempts to determine the value of an
investment today, based on projections of how much money
that investment will generate in the future.
How to compute intrinsic value using DCF?
Using discounted cash flow (DCF) analysis, cash flows are estimated
based on how a business may perform in the future. Those cash flows
are then discounted to today’s value to obtain the company’s intrinsic
value. The discount rate used is often a risk-free rate of return, such as
that of the 30-year Treasury bond.
• It can also be the company’s weighted average cost of capital
(WAAC).
Steps to compute intrinsic value.
1. Determined the current cash flow.
2. Find the growth rate.
3. Find the terminal value
4. Find the discount rate.
Discounted Cash Formula
Discounted cash flow formula
DCF = CF1/(1+r)1 + CF2/(1+r)2 + . . . + TV/(1+r)n
CF = the expected cash flow for a specific period (e.g., CF1 = cash flow year one)
r = the discount rate
TV = the terminal value (estimated cash flow after the projection period)
• n = the specific period (e.g., years, quarters, months, etc.)
Example
As an example, let’s use the earnings available to investors from our Acme Bolt Company as cash flow. Say this
figure is $200 (after adding depreciation and subtracting capital expenditures) for the latest year. If a
hypothetical P/E multiple for the S&P 500 is 15, Acme’s per share market value is $3,000 (15 x $200). We’ll use
that figure for the comparison to intrinsic value.
Using an estimated growth rate of 7%, the estimated cash flow for each of 10 years is:
Year 1: $214.00 (200 x 1.07)
Year 2: $228.98 (200 x 1.072)
Year 3: $245.00 (200 x 1.073 and so forth)
Year 4: $262.16
Year 5: $280.51
Year 6: $300.15
Year 7: $321.16
Year 8: $343.64
Year 9: $367.70
Next, we discount these cash flows using a theoretical 30-year T-Bond rate of 3.3%. We
apply it using the discounted cash flow formula. For example, the formula for the first year
is CF/1 + r. The discounted cash flow for each of 10 years is:
Year 1: $207.16 (214/1.033)
Year 2: $214.58 (228.98/1.0332)
Year 3: $222.26 (245/1.0333 and so forth)
Year 4: $230.23
Year 5: $238.48
Year 6: $247.02
Year 7: $255.87
Year 8: $265.03
Year 9: $274.53
• Year 10: 284.35
Roles of Valuation in
Business
Portfolio Management
Fundamental Analysts
• Are the persons who are interested in understanding
and measuring the intrinsic value of a firm.
• Fundamentals refer to the characteristics of an entity
related to its financial strength, profitability or risk
appetite.
Fundamental Analysts
• Growth Investors lean
• Value Investors tend to towards growth assets and
be mostly interested in purchasing these at a
purchasing shares that are discount.
existing and priced at less
than their true value. Growth assets – businesses
that might not be profitable
now but has high expected
value in future years.
Legal and Tax Purposes
New Entrants
• Refers to the barriers to entry to industry by new market players.
• High entry costs means fewer new entrants, thus, lesser competition
which improves profitability potential.
• New entrants include entry costs, speed of adjustment, economies of
scale, reputation, switching costs, sunk costs and government
restraints.
